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Getting major financial decisions right makes up for a lot of little misfires. And one of the biggest decisions people face is deciding when to buy a home.
To make the right call, it’s important to avoid some common misconceptions that surface when people try to compare the benefits of owning a property versus renting.
Is a Residence An Asset or Liability?
For many, owning a home is a quintessential part of the American Dream.
There are experiential perks to owning a home. It promotes a feeling of stability. And there’s more freedom to make property improvements.
Renting has its own set of perks, including the freedom that comes with being able to pack up and move easily. Also, you don’t have to worry about burdensome maintenance costs.
These qualitative variables are pretty straightforward. But once you start getting into numbers, things get fuzzy.
Let’s start with some definitions. Many folks consider their home an ‘asset,’ but that’s not automatically true. In certain cases, a home can be a liability. Here is a simple litmus test:
- Assets put money into your pocket.
- Liabilities take money out of your pocket.
Now that we have that straight, let’s turn our attention to the numbers.
Real Estate Returns
Real estate has generated pedestrian returns compared to other asset classes. I’m aware someone sitting on a highly appreciated property in California may not agree with that statement, but it’s the long-term national average.
Yale economist, Robert Shiller, has research showing that from 1915 to 2015, U.S. home prices appreciated 0.6 percent per year net of inflation.
Credit Suisse reached a similar conclusion in a 2018 study. They compared real estate returns across 11 countries from 1900 – 2017. The black line in the graph below shows the average result, which was an annualized real return of 1.3%.
Sources: Dimson, Marsh, Staunton
Credit Suisse Global Investment Returns Yearbook 2018
“House prices did not grow at a steady rate… over the first half of the 20th century, average house prices did not move at all in real terms,” according to the report.
“Prices started to rise in the 1950s, with an even stronger showing in the 1960s. However, the highest period of growth was from the mid 1990s until the eve of the Global Financial Crisis, when real house prices rose by 6.2% per year.”
So, recency bias likely inflates many folks’ perception of returns. Also, they overlook the role leverage plays. The average retiree would never lever their stock portfolio five times. But if they own a home, that is a levered investment. That means higher returns if the property appreciates, and higher risk if it doesn’t.
It’s mentally easier to carry leverage on real estate, because there isn’t a daily price quote on the front door. But if you ask anyone who bought real estate in a hot market in 2006, they’ll tell you real estate is indeed risky.
Hidden Costs
The financial benefits linked to owning a home are generally well acknowledged. They include an opportunity for price appreciation and tax deductions linked to mortgage interest.
In spite of these benefits, though, most folks would be better served to view their personal residence through a consumer lens, i.e. a liability. That’s because many of the perceived financial rewards are not what they first appear.
Say a friend sells their house for $500,000. They are quite happy, because they originally paid $400,000. On the surface, it’s a 20% return.
But under the surface, there are costs that take a bite out of that return. For instance, you must deduct transaction costs, which often means paying 5% to a broker.
Other costs:
- Opportunity cost of not being able to invest your down payment
- Property taxes
- Maintenance costs
If you strip these costs out, you can more accurately compare the monthly cost of owning versus renting. And that varies a lot by region.
According to research from CJ Patrick Co., based on data from First American Data Tree, the nation’s top 50 metropolitan areas are evenly split on the rent versus own calculation.
Their study looked at median rent prices, median home sale prices, and taxes and insurance. And they only considered homes in the lowest quarter of the price scale, which would typically be purchased by first-time buyers.
They found cities in the Midwest and South generally favored buying. For example, Memphis, Tennessee had a monthly rent cost of $914, which was almost double the cost of owning.
In California, where property prices are much higher, it is generally cheaper to rent than own.
In summary, before you make one of the biggest financial decisions of your life, make sure you know your numbers, the real rate of return, and your local market dynamics.